As cash flows to companies after tax reform, here's how to invest

Take advantage of a likely pickup in mergers and acquisitions through financial services funds and bank stocks

One reason lotteries are so popular is that most people like to dream about what they would do with vast amounts of money — enough to buy a private island, for example, or pick up a dozen Fabergé eggs on the way home.

Corporations will soon be coming into a vast windfall, thanks to tax reform, and already Wall Street is speculating what they will do with all that cash. While increased stock buybacks and dividends are likely, so are outright purchases — merger and acquisition activity. You can take advantage of all that buying and selling through merger arbitrage funds and deep-value funds, but the best way is probably through financial services funds and bank stocks.

It's not like companies don't have plenty of cash already. Cash in the nonfinancial sector of the Standard & Poor's 500 stock index rose $50 billion, to $1.58 trillion, in the third quarter. Current cash levels represent twice the amount of trailing 12-month income, notes Howard Silverblatt, senior index analyst for S&P.

Having lots of cash — with the reasonable expectation of lots more — is a wonderful thing. The question then becomes what to do with it. In recent years, buying back stock has been the method of choice for getting rid of all that pesky cash, even though evidence that companies are particularly good buyers of their own stock is sparse. And aside from reducing the company's stock float, buybacks do little to increase a company's output or market share.

Dividends are another favorite way to return cash to shareholders, but they have one drawback: Once a company increases its dividend, Wall Street expects it to continue paying at that level. General Electric discovered that the hard way earlier this year, when it cut its dividend payout by half.

Companies could also reinvest their cash in themselves, either by hiring more employees, giving existing employees raises, or increasing plants and equipment. The enthusiasm for raises or other investments seems lukewarm, at least judging by the response White House economic adviser Gary Cohn saw at the Wall Street Journal's CEO Council. The Journal's John Bussey asked for a show of hands from CEOs who planned to increase investment with their tax cut, and got just a smattering of hands, prompting Mr. Cohn to ask, "Why aren't the other hands up?"

So, we're likely to see a chunk of buybacks, some increased dividends and a tad of reinvestment with any new cash delivered by tax cuts and repatriation of cash from overseas. But companies have another option: buying other companies. And, in fact, companies have two attractive options for purchasing other companies. The first, of course, is cash. The second is their already inflated share prices, notes Sam Stovall, chief investment strategist at CFRA. That's particularly true late in a market cycle.

More broadly, deregulation also could be a driver of M&A activity, said Sal Bruno, chief investment officer for IndexIQ.

"Companies find ways to adapt," Mr. Bruno said. "Sometimes the right way might be to merge or buy someone else."

Finally, there's what Mr. Bruno calls the hypercompetitiveness of the global economy.

"Amazon didn't buy Whole Foods because supermarkets are a strategic addition to their business," he said. "They thought it was an industry that could be disruptive."

So how does an investor play the M&A boom? One way is via merger arbitrage, which is a conservative way to generate returns by shorting the acquirer and going long the target. (Typically, the price of the target rises because the acquirer overpays, which pushes down its price). You should get returns that are somewhat better than cash and an investment that's negatively correlated to the bond market, Mr. Bruno said.

Two active funds to consider: The Arbitrage Fund (ARBFX), one of the oldest arbitrage funds in the business, and AQR Diversified Arbitrage (ADAIX), which also boasts a seasoned team. The AQR offering has had a particularly good year, thanks to its move into special-purpose acquisition companies — basically, publicly traded buyout companies. For ETF investors, there's IQ Merger Arbitrage ETF (MNA), which has produced excellent returns the past five years and sports a lower expense ratio than its actively managed rivals.

You can invest in the move to merge in two other ways. The first is to look at an absolute value fund, which tends only to buy dead cheap companies. After all, those are most likely to get bought out. The technique is probably best for small- and midcap value funds. Large-company stocks have had tons of cash for years, and haven't embarked on a buying spree.

"If you give Apple another billion, are they going to change?" Mr. Silverblatt said.

But academic research indicates that when allowed to repatriate overseas cash, small- and midcap companies are more inclined to embark on M&A activity — precisely because they didn't have enough to do so before.

A riskier strategy is to simply increase your holdings in large banks, through an index holding like Financial Select SPDR (XLF) or Vanguard Financials ETF (VFH). These funds are weighted toward the larger banks, and that's good.

"The big houses will do better because they have the resources to do M&A," Mr. Silverblatt said.

And they will do particularly well if one other factor enters the M&A cycle: Ego.

"If you've ever watched poker at a table with big egos and a lot of money, there's nothing better."

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